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Twin-deficit worries resurface
After a benign few years, India’s twin-deficit challenge appears to be re-surfacing. The fiscal deficit slipped by 30 basis points (bps) from the budget target in current fiscal year and the current account deficit (CAD) is on an upward trajectory. Though not a cause for alarm as yet, it does warrant close monitoring.
This month’s theme attempts to deconstruct India’s rising external imbalance to assess the extent of threat it poses. India’s CAD is set to touch 2.0% of GDP in fiscal 2018 from 0.7% in fiscal 2017 and 1.2% in fiscal 2016. We estimate CAD at 2.5% of GDP in fiscal 2019- the upper bound of the safe limit.
The global environment has been a mixed blessing. Global growth and trade have revived but so have oil prices. Additionally, the protectionist winds threaten to blow away trade recovery. Among India’s top export markets, the US, Germany, and the UK have the highest number of restrictive policies that affect India. India too has responded by raising import tariffs on a few items.
Without doubt crude oil price increase is one of the key factors behind rising CAD as the bulk of our demand is met via imports. We estimate that a $10 rise in price of crude oil pushed up CAD/GDP by 60 bps. But, the reasons for our rising external imbalance extends beyond oil and protectionism.
A shrinking trade surplus with India’s major export destinations, including the European Union (EU), the US (which are currently witnessing a strong cyclical upturn), and the United Arab Emirates, has contributed to the widening trade deficit. Part of the reason for this is demonetisation-related transitory disruption and Goods and Services Tax-related glitches faced by exporters.
The rupee has appreciated against major trading partners in real terms. Although exchange rate is not a dominant determinant of trade, its appreciation encourages imports and discourages exports.
In fiscal 2018, private consumption slowed yet imports rose sharply. Also, import growth was broad-based, with all these categories witnessing an acceleration. The proximate reasons for this are domestic production disruptions amid slowing consumption and GDP growth. In electronic items which are witnessing a sharp increase in domestic demand are largely imported.
Agricultural trade surplus has shrunk from over $20 billion in fiscal 2014 to below $5 billion in fiscal 2018. Collapse of demand and prices in crops such as guar gum and cereals tamped down agricultural trade surplus.
As pointed out in our earlier studies, India is losing out to more competitive markets such as Bangladesh and Vietnam in garments exports.
Some of the above constraints to trade are cyclical in nature, the others such as falling competitiveness are structural and will not ease without require concerted policy effort.
Despite brewing problems in the external account, a few recent data releases brought some cheer. Consumer price index (CPI)-based inflation slid to 4.4% in February from 5.1% in January, marking the second consecutive month of decline. In the last quarter, it is set to undershoot the Reserve Bank of India’s (RBI’s) forecast.
But that does not mean the RBI will cut rates. We expect a pause through the first half of fiscal 2019 followed by a possible hike of 25 bps in the second half as inflation risks have yet not abated. The Index of Industrial Production continued its strong growth momentum and printed a broad-based 7.5% growth in January.